Ramesh has just received his annual bonus of Rs 3 lakh. He has a home loan for Rs 35 lakh with a private bank, and pays interest at 11 per cent per annum. The equated monthly instalment (EMI) paid by Ramesh is Rs. 34,500. He wishes to reduce this huge burden progressively.

The long tenure of a home loan results in a substantial interest outflow, in addition to the huge principal repayment. In most cases, the total interest repaid is more than the original loan amount. A considerable portion of the EMI goes towards the interest component, and only a minuscule portion is allocated towards principal. As in the case of several borrowers, Ramesh also faced this problem. How can he reduce this burden?

Ramesh has two choices: Either increase the EMI amount to reduce loan tenure, and the interest outflow, or part-prepay the loan with the bonus he received. Ramesh found the latter option more feasible. But he had another dilemma of whether to repay the loan or to invest this amount in good investments. Let us look at both the cases:

When to Prepay?

A major portion of the EMI is allocated towards interest, especially during the initial 5-8 years of your loan. This is the best time to part-prepay the loan. When you prepay, the full amount goes towards reducing the principal. This in turn reduces the total loan period and total interest outflow.

If you are placed in a situation, which does not assure a regular income, you should prepay your loan whenever you receive any windfalls.

Another factor to be taken into account is the interest rate scenario in the economy. If there is an expectation that interest rates may harden, you should prepay as an increase in rates will result in an increase the interest burden on your floating rate home loan as well. In this scenario, you may end up paying a higher EMI, or there will be an increase in the loan tenure. Remember, it is always better to reduce the tenure and pay off the entire loan before retirement.

The most common deliberation is whether to use the cash to reduce the home loan amount or to invest this amount. You can prepay when the interest rate on your home loan is higher than the post-tax interest rate you earn from your investments. Do remember that interest rate cycles move up and down and so returns from equity-related instruments can be volatile.

When not to Prepay?

Compare the returns from your investment and the interest on your home loan. Invest the lump sum cash received if the post-tax return from your investment works out to be higher than the home loan rate. You must also consider the tax benefits of a home loan for both principal and interest components. So when the rates are compared, the reduction in tax outflow due to these deductions must be factored. Investing in fruitful investment avenues makes sense if you are below 35, as you can repay the loan before retirement.

The third option

Yet another option is to port your home loan to another bank, which charges a lower interest rate. As RBI has waived prepayment charges on floating rate home loans, even if you do a balance transfer to another bank, you can now easily shift banks without incurring high costs. While the interest rate is the most important factor to be considered when you shift banks for home loans, remember to consider a few other things. An important expense you will incur is the processing fee charged by the new bank. In addition to this, you may also have to incur expenses on stamp duty and related charges and insurance premium (some banks require you to compulsorily take a fire insurance for your house).

Your existing lender may offer you a lower interest rate if you pay conversion fee, which is more or less equal to the processing fee in the new bank. If this reduced interest rate is the same as the new lender’s rate, it is better to stay with the existing lender.

Your decision to part-pay the loan or not depends on several factors. Remember you must always try to maximise your earnings, either by reducing your interest outflow or by maximising your investment returns.

— The author is CEO, BankBazaar.com

http://www.indianexpress.com/news/to-invest-or-prepay–a-crucial-decision/1105045/0